Author(s): Brent R. Cohen
Published: 01/20/2009
In two recent federal circuit court cases, lenders have found themselves on the losing side of preference actions arising from delays in making the necessary filings to perfect their liens. See Caillouet v. First Bank and Trust (In re Entringer Bakeries, Inc.), ___ F.3d ___ 2008, WL 4821613 (5th Cir. Nov. 6, 2008), and Chase Manhattan Mortgage Corp. v. Shapiro (In re Lee), 530 F.3d 458 (6th Cir. 2008). In each case, the fact pattern presented a set of common circumstances, summarized as follows:
- Original lender makes loan secured by real or personal property.
- Refinancing lender makes second loan, the proceeds of which are used to pay off the indebtedness owed to original lender. Upon receipt of payment, original lender releases its lien or security interest in the collateral.
- For no particular reason, refinancing lender waits more than 30 days to perfect its lien by filing the necessary encumbrance against the real property or financing statement with respect to personal property.
- Within 90 days after refinancing lender's lien or security interest is perfected, borrower files a bankruptcy petition.
- Chapter 7 Trustee files an adversary proceeding against refinancing lender seeking to avoid the lien or security interest on grounds that it was perfected within the 90-day preference period.
Under Section 547 of the Bankruptcy Code, a transfer made on an antecedent debt within 90 days of the filing of the bankruptcy petition can be avoided, and the value of the transfer recovered, if the borrower was insolvent at the time the transfer was made and the effect of the transfer would be to allow the transferee to recover more than a general unsecured creditor in a Chapter 7 liquidation proceeding. Receipt of a payment within the preference period does not necessarily mean there is a viable avoidance action. As discussed below, a variety of defenses are available to a preference claim.
From the perspective of the refinancing lender in our hypothetical instance, the perfection of the lien or security interest constitutes a transfer for purposes of Section 547 of the Bankruptcy Code. The question is whether the other elements for an avoidable transfer under Section 547 have been met.
- The transfer took place within 90 days of the filing of the bankruptcy petition;
- The transfer was for the benefit of a creditor—the refinancing lender;
- The transfer was for or on account of an antecedent or preexisting debt owed by the borrower;
- The transfer was made while the debtor was insolvent, a fact that is presumed if the transfer took place within 90 days of the filing of the bankruptcy petition; and
- The transfer enabled the refinancing lender to receive more than it would have received in a Chapter 7 liquidation—meaning that the refinancing lender is claiming collateral that would not otherwise be available to an unsecured creditor.
As mentioned above, there are potential defenses to a preference claim. For instance, it might be argued that the perfection of the lien or the security interest was a substantially contemporaneous exchange for purposes of Section 547(c)(1) of the Bankruptcy Code. This means that the transfer received by the refinancing lender was intended as, and was in fact, a substantially contemporaneous exchange. The problem here is that the refinancing lender waited in excess of 30 days to record evidence of its lien. Section 547(e)(2) creates a "safe harbor" for creditors perfecting liens within 30 days after the loan is made. This change was implemented as part of the amendments to the Bankruptcy Code enacted in 2005. Prior to then, secured creditors were given only ten days to perfect their liens in order to rely on the safe harbor.
Another defense involves what is known as the "earmarking doctrine." This is a judicially created defense to a preference claim that applies where it can be shown that the assets from a third-party lender, such as the refinancing lender, were never in control of the debtor and therefore payment of these assets to a creditor in no way diminishes the debtor's estate. In Entringer Bakeries and Lee, each court confirmed the earmarking doctrine as a valid defense to a preference claim. However, each determined that, under the circumstances, the earmarking doctrine could not be applied. Each court reasoned that the lien interest granted by the borrower did not involve a transfer of "earmarked" property. Instead, the perfection of the lien involved the transfer of what was undoubtedly property owned and controlled by the borrower. To the extent this represented a diminution of the bankruptcy estate, the earmarking doctrine could not be applied.
It bears mentioning that at least one circuit court reached the opposite conclusion, finding that the release of the lien associated with the refinancing and the grant of the subsequent lien to the refinancing lender should be viewed as a single transaction in which there was no net reduction in the bankruptcy estate. See Kaler v. Community First National Bank (In re Heitkamp), 137 F.3d 1087 (8th Cir. 1998). The issue has not been addressed in this particular context in the Tenth Circuit, which includes Colorado, Wyoming, Utah, and Kansas. However, the lesson of these rulings is abundantly clear. Every effort must be made to perfect a lien or security interest by recording the encumbrance or filing a financing statement within 30 days in order to take advantage of the safe harbor provided under Section 547(e) of the Bankruptcy Code. Any further delay in the perfection of the lien places the lender at risk of losing its collateral in the event that a bankruptcy petition is filed.
Brent R. Cohen, a partner with Rothgerber Johnson & Lyons LLP, is the senior member and chair of the firm's Bankruptcy Department. Mr. Cohen has been exposed to a wide variety of bankruptcy and insolvency matters throughout the United States. His practice includes representation of debtors, creditors, and trustees in bankruptcy and insolvency proceedings, as well as workouts and restructurings outside of court. He regularly provides bankruptcy advice in conjunction with a variety of complex commercial transactions and has participated in some of the more significant bankruptcy litigation in the Rocky Mountain area. Mr. Cohen has also had extensive involvement in oil and gas, debtor/creditor, and commercial litigation. He is admitted to practice in state and federal courts in Colorado and Wyoming. Mr. Cohen can be reached at 303-628-9521 or at bcohen@rothgerber.com.